Reading Financial Reports for Dummies (49 page)

If you’re a shareholder, the company notifies you about the date and location of the meeting. In addition to asking questions, shareholders vote on any open issues. Almost every annual meeting includes the election of at least some members of the board of directors. Most companies stagger the election of board members over a number of years so that the entire board doesn’t change in one year. Other issues that involve major changes to the way the company does business are also voted on, such as a change in executive compensation.

Sometimes shareholders add their own issues to the agenda. For example, environmentalists who own stock in a company may seek a shareholder vote on how the company gets rid of its waste (to ensure that controls to protect the environment are in place) or how it develops land it owns near a wildlife preserve (to be sure wildlife is protected during and after construction).

Sometimes a corporation calls a special meeting if the shareholders must vote on a significant issue before the next annual meeting. A possible merger is one of the most common events that spur such a special meeting.

Innovative companies see annual meetings as a way to communicate effectively with their investor base. The problem for many firms is that most shareholders don’t show up. But the Internet can help reach them — some companies place all their meeting materials on a Web site, and some companies also Webcast the meeting itself and archive it for shareholders to watch at their leisure.

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Checking Out How the Board

Runs the Company

Corporate governance
is the way a board of directors conducts its own business and oversees a corporation’s operations. Ultimately, the board of directors is liable for every decision the company makes, but in reality, only major shifts in the way the company operates make it to the board for decision. For example, if executives recommend that the company take on a new product line that would involve a large investment of cash, the board would be consulted for this decision. However, most day-to-day decisions are left to the company’s executives and managers.

Watching the directors

The shareholder landscape changed dramatically after the corporate scandals of the 2000s exposed severe corporate governance problems, beginning with the collapse of Enron. Today, shareholder groups — many led by institutional investors such as pension plans and mutual funds that own large blocks of shares in various companies — closely watch the following four major issues in the companies in which they own shares of stock.

Composition of the board of directors

Shareholder groups monitor the makeup of the board, how board members are chosen, and how many members serving on the board are truly independent — meaning that they’re not directly involved in the day-to-day operations of the company. Outsiders prefer that a majority of the board members be independent because independent board members can be more objective (they aren’t protecting their own jobs and their own income).

CEOs get better raises

Most working Americans would be delighted

can check out how much the CEOs of com-

if they received pay raises anywhere near panies you’re interested in tracking are paid the ones that CEOs got in 2007. According to

at the Executive Pay Watch database, run by

Executive Pay Watch,
the average total com-

the AFL-CIO online (www.aflcio.org/

pensation for a Fortune 500 CEO was $14.2 mil-

corporatewatch/paywatch/pay/

lion. That’s up from $10.8 million in 2006. You

index.cfm).

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Compensation packages for board members and CEOs

These details are on public record now. In addition, shareholders must approve of or be notified of any major benefits or compensation offered to the company’s executives, such as
stock-option plans
(offers to buy company stock at prices below market value). Shareholders complain bitterly if they believe executives are receiving excessive compensation.

Takeover defenses and protections

In some cases, board members place defenses against the possibility of a company takeover. For example, Comcast unsuccessfully attempted a hostile takeover of Disney during the battle between shareholders, led by Roy Disney, who was attempting to oust Michael Eisner. Sometimes these defenses help protect shareholders from a corporate raider who wants to buy the company and sell off the pieces, which can leave shareholders with stock that’s worth very little. Other times these defenses prevent a takeover by some other company that may benefit the shareholders but not the current management team and board of directors (especially if the leadership ranks would change under the new owners, and they could lose their jobs).

Shareholder groups watch whatever takeover defenses or protections the board puts into place to be sure their best interests are protected, not just the best interests of the directors and the management team.

Audits

The primary responsibility of the board of directors is to review the audits of the company’s books to be certain that they’re being done accurately by both the internal accounting team and the external auditors. Today, the Securities and Exchange Commission (SEC) requires that independent board members make up the audit committees. Prior to the Enron scandal, many audit committees weren’t as independently run, which allowed company insiders to control not only how money was spent but also how it was recorded in the company’s books and how the financial results were reported to outsiders. This insidious practice allowed top executives to more easily hide any misdeeds or misuse of funds.

Speaking out at meetings

Shareholders can voice their opinions during annual meetings and during any special corporate meetings called by the board of directors to address a specific issue. At these meetings, shareholders cast weighted votes, called
proxy
votes,
based on the number of shares they hold. If board members aren’t responsive to shareholder concerns on any of the issues in the preceding list, they may find themselves defending a major challenge at the annual meeting.

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Hewlett-Packard’s costly clash

Walter Hewlett, son of one of the co-founders

In addition to the costly advertising, Hewlett-

of Hewlett-Packard, led one of the most costly

Packard’s board racked up about $70 million in

battles against a CEO and a board of directors

expenses to defend its merger decision, includ-

when he tried to stop a merger with Compaq.

ing an estimated $3 million to individually call

Hewlett lost the fight when the final vote of the

its shareholders and another $25 million in mail-

shareholders ended in approving the merger.

ings to its shareholders. Hewlett-Packard also

paid $33.5 million to investment banker Goldman

Hewlett reported that he spent $32 million on

Sachs, which handled the merger deal. Analysts

his attempt to stop the merger. Financial ana-

guesstimate that Hewlett-Packard’s total cost

lysts speculate that Hewlett-Packard’s board

for this fiasco was $100 million to $125 million,

of directors, led by CEO Carly Fiorina, spent and a good portion of that money was neces-at least twice that much on advertising in the

sary only because of the shareholder battle.

major media markets where most of Hewlett-

Packard’s shareholders live, plus on other

actions, to defend its merger decision.

Prior to the Enron scandal, a shareholder rarely brought forth an issue for the rest of the shareholders to vote on; most often, the corporation’s board of directors controlled what the shareholders voted on. If a shareholder issue even made it to the point of being voted on by the other shareholders, it rarely had a chance of passing. Today, shareholders are more successful at getting issues on the agenda to be voted on at an annual meeting; sometimes they win the proxy vote, and sometimes they lose.

A proxy fight can cost a corporation millions of dollars no matter who wins, as illustrated by Hewlett-Packard’s pricey battle in 2001 and 2002 (see the sidebar “Hewlett-Packard’s costly clash”).

Moving away from duking it out

Since the success of the shareholder fight to oust Michel Eisner from the chairmanship of Disney’s board of directors in 2004, corporations have been finding ways to negotiate with unhappy shareholders rather than fight it out in a proxy vote.

To avoid a costly proxy fight, boards of directors negotiate with unhappy shareholders by meeting with them quietly behind closed doors and discussing the issues on which they disagree, with the hope that they can find a 286
Part V: The Many Ways Companies Answer to Others

solution that both sides can accept. If the shareholders and the board fail to find common ground, a proxy fight is likely. Knowing that a proxy fight can cost millions, more corporations are wising up to the fact that they should listen to their shareholders.

One of the major leaders of proxy fights are large institutional shareholders, along with the help of other state retirement systems and some mutual funds.

These large institutional investors hold large blocks of stock in their pension or mutual-fund portfolios, so they have a lot to lose if a company doesn’t do what they believe it should do.

Many times, the issues include how the board of directors operates and how many independent directors serve on the board and its various committees, particularly the audit committee. New rules about independent directors were adopted after the Enron scandal. Under revised SEC Rule 10A-3, a public company must appoint independent directors to the audit committee, and the committee must establish procedures for complaints regarding accounting, internal accounting controls, or auditing matters, including procedures for employees to confidentially and anonymously submit concerns regarding questionable accounting or auditing issues.

Sorting through Reports

Mailing out reports on an annual and quarterly basis is the primary way a corporation informs its shareholders about its performance. Usually, the corporation mails the annual report before the annual meeting, along with information on the proxy votes that will take place at the meeting. Proxy information is a critical part of the annual report package, as voting by proxy is the primary way shareholders get to voice their position on board decisions.

The mailing also includes information about the board’s position on any issues that will be presented at the annual meeting. If the board brings an issue to the shareholders for a vote, the board explains the issue and its position. If a group other than the board brings the issue to the shareholders, the board states the issue and discusses why it’s in favor of or opposed to the issue. In most cases, the board opposes issues brought by outside sources.

An outside group raising or opposing an issue is also likely to mail its position to the shareholders. In fact, Walter Hewlett spent about $15 million mailing information to Hewlett-Packard shareholders in an attempt to stop the merger with Compaq, which I discuss in the earlier sidebar “Hewlett-Packard’s costly clash.”

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Catching Up on Corporate Actions

Corporations must report special events to their shareholders as soon as the event can
materially impact
the company’s results (affect the profits or losses of the company). The most common special events include:

✓

Acquisitions:
Before a company can finalize plans to acquire another company, it must report those plans to its shareholders.

✓

Class-action lawsuits:
If a company is the defendant in a class-action lawsuit that can have a material impact on its results in the future, the company must report the lawsuit and discuss its potential impact with shareholders.

✓

Mergers:
If two firms plan on merging, the firms’ management must inform their shareholders and also ask them to vote on the merger. If shareholders in either company vote against the merger, the deal will probably be cancelled. Sometimes, companies may revise the deal and attempt a second shareholder vote.

✓

Dividends:
Whenever the board decides to pay dividends, it has to report that information to the shareholders. Of course, dividends are one of the few things that boards enjoy reporting, so they usually make a very public announcement to shareholders about the dividend payments.

✓

SEC investigation:
If a company discovers that the SEC is investigating it, the company must report this knowledge to its shareholders in a timely manner.

✓

Stock splits:
A
stock split
is when the board decides to make one share of stock worth more than one share. For example, a stock split may be two shares for one, which means that each shareholder gets two shares of stock for each share that he holds. Most times, a company announces a stock split when it believes the price of its stock has gotten too high for the market. So a stock that sells for $100 before a two-for-one stock split will sell for $50 a share after the split.

In short, a company must give its shareholders the lowdown on anything that materially impacts the business’s value. In fact, companies must report to the public and to financial analysts within 24 hours of telling any company outsider about a major event, such as the ones I list in this section, that could impact a company’s net income materially.

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Introducing fair disclosure

Today, the SEC requires that a company release

days before the general public about upcom-

all information that can significantly impact its

ing key events or other financial data. When